A GARCH Option Pricing Model with Filtered Historical Simulation

54 Pages Posted: 15 Oct 2004 Last revised: 29 Apr 2008

Giovanni Barone-Adesi

Swiss Finance Institute at the University of Lugano; Ecole Polytechnique Fédérale de Lausanne - Ecole Polytechnique Fédérale de Lausanne

Robert F. Engle

New York University - Leonard N. Stern School of Business - Department of Economics; New York University (NYU) - Department of Finance; National Bureau of Economic Research (NBER)

Loriano Mancini

Ecole Polytechnique Fédérale de Lausanne; Ecole Polytechnique Fédérale de Lausanne - Ecole Polytechnique Fédérale de Lausanne

Multiple version iconThere are 2 versions of this paper

Date Written: January 2008

Abstract

We propose a new method for pricing options based on GARCH models with filtered historical innovations. In an incomplete market framework, we allow for different distributions of historical and pricing return dynamics enhancing the model flexibility to fit market option prices. An extensive empirical analysis based on S&P 500 index options shows that our model outperforms other competing GARCH pricing models and ad hoc Black-Scholes models. We show that the flexible change of measure, the asymmetric GARCH volatility and the nonparametric innovation distribution induce the accurate pricing performance of our model. Using a nonparametric approach, we obtain decreasing state price densities per unit probability as suggested by economic theory and corroborating our GARCH pricing model. Implied volatility smiles appear to be explained by asymmetric volatility and negative skewness of filtered historical innovations.

Keywords: Option pricing, GARCH model, state price density, Monte Carlo simulation

JEL Classification: G13

Suggested Citation

Barone-Adesi, Giovanni and Engle, Robert F. and Mancini, Loriano, A GARCH Option Pricing Model with Filtered Historical Simulation (January 2008). Review of Financial Studies, 2008. Available at SSRN: https://ssrn.com/abstract=603382 or http://dx.doi.org/10.2139/ssrn.603382

Giovanni Barone-Adesi (Contact Author)

Swiss Finance Institute at the University of Lugano ( email )

Via Buffi 13
CH-6904 Lugano
Switzerland
+41 58 666 4671 (Phone)
+41 58 666 46 47 (Fax)

Ecole Polytechnique Fédérale de Lausanne - Ecole Polytechnique Fédérale de Lausanne

c/o University of Geneve
40, Bd du Pont-d'Arve
1211 Geneva, CH-6900
Switzerland

Robert F. Engle

New York University - Leonard N. Stern School of Business - Department of Economics ( email )

269 Mercer Street
New York, NY 10003
United States

New York University (NYU) - Department of Finance

Stern School of Business
44 West 4th Street
New York, NY 10012-1126
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Loriano Mancini

Ecole Polytechnique Fédérale de Lausanne ( email )

Quartier UNIL-Dorigny
Bâtiment Extranef
1015 Lausanne, CH-1015
Switzerland

HOME PAGE: http://sfi.epfl.ch/mancini.html

Ecole Polytechnique Fédérale de Lausanne - Ecole Polytechnique Fédérale de Lausanne ( email )

c/o University of Geneve
40, Bd du Pont-d'Arve
1211 Geneva, CH-6900
Switzerland

Paper statistics

Downloads
2,799
Rank
3,047
Abstract Views
10,327